Renegade Economists 284
Leading economics – energy – environment commentator Nicole Foss joins to discuss the state of finance. She is in Australia on an extensive speaking tour. Support her work and your economic literacy by attending!
KF: Nicole, in terms of systems thinking, how does The Automatic Earth function?
NF: Well, basically the idea is to look at as many different subsystems of reality as possible and understand how the system works – what the time constants for change are in that particular system, and that allows you to prioritize which systems are going to be the key drivers at what time. Then the idea is to integrate those subsystems and get a picture of reality. We prioritize finance because finance has the shortest time constant, so it is going to be hurdle number one over the next few decades. Then, we would look at energy as being hurdle number two. Then we would look at resource shortages, carrying capacity, population, pollution, climate, psychology, realpolitik and all manner of other things – so the idea is to have the biggest possible “big picture” so people can navigate their way through a time of uncertainty and upheaval.
KF: In more detail, explain why finance is first cab off the rank.
NF: Because the world of finance is mostly virtual, and the time constant for change in virtual systems is really short. So what happens is when you reach a limit in finance – and these limits are endogenous, you don’t need to trigger an event – you reach a limit in finance, and the changes can be extremely rapid. So if you look at what happened in Cyprus for instance, in two weeks they went back 50 years – they went from being a modern economy to having the banks closed, the ATMs empty, the shops shelves mostly empty, a cash-only economy, capital controls, and the value of these banks went from their full value down to next to nothing in a very short space of time. And so when you have the value of human promises suddenly disappearing, you crash the system.
So the money supply is mostly credit – the vast majority of it is credit, which just means human promises to repay – these have value as long as we believe the promise. As soon as we stop believing the promise, the value goes away all at once. Then you can end up with a tiny fraction of what was previously your money supply. Then because there is no money in circulation, – and money is the lubricant in the engine of the economy, like motor oil is the lubricant in the engine of your car, -because there is no lubricant, the engine seizes up on you. You can’t collect buyers and sellers, producers and consumers, and you have an economic depression. So, because this can happen so fast and it is a very large impact, it amounts to crashing the operating system. When you crash the operating system, you can’t do anything with your resource base until you reboot the operating system. That’s really what these periods are, and this is why it’s the first hurdle because it simply happens so quickly.
KF: How then can we look to reform the finance system when we’ve essentially forfeited democracy to these banksters?
NF: I don’t think you can reform it – I think it’s beyond anybody’s control and history teaches that we have these large structures that rise and fall all the time. This is just our form of empire – our form of economic imperialism, and we’re going to see that collapse and then we will do something different. But, I don’t think it is a question of reforming what is already there – I think it will collapse all by itself. We don’t really have to do anything about that, we just have to concentrate on building something that comes out of the other side.
So it is “how do we reboot the operating system?” – there is no point trying to build a better dinosaur, let’s be mammals. The dinosaurs are going extinct anyway, no matter what anybody does. So let’s concentrate on building new systems of government from the bottom up – new systems for money, new operating systems. That tends to be my focus – I would say that all the large scale things will not work when you have a very large scale economic contraction, because trust determines effective organisational scale. You lose trust when the economy contracts – you lose political legitimacy at that high level of organisation, so those things over time go away anyway, and then you need to work at an effective organisational scale that’s much smaller and reboot the operating system from there.
KF: You’re talking about resilience there and creating resilience at a local level. How does that flow through then in terms of practical outcomes? You’re talking about money and creating new ways of creating trust. What are you proposing on the monetary front?
NF: Well, basically we would have to go through a similar kind of process to the way money developed in the first place because money is an emergent property of scale meaning that as you scale up the size of your society you have to have more sophisticated mechanisms for exchanging value. So initially you would go from, say, a gift economy to perhaps time-banking. When you get large enough that you don’t know everybody personally, it is hard to have just a gift economy, so you start keeping track of who has put what hours into the system. You get a little larger and you would be looking at some kind of currency to allow you operate more efficiently so you don’t have to work out how many eggs a bunch of bananas is worth and things like that – you have some abstract mechanism for exchanging value.
When you scale up to a great extent, now you have to move away from the personal into the transpersonal, so you have an institutional framework instead, and the trust that is surrounding the monetary system goes from being placed in people to being placed in the institutional framework. So that’s where we are now – we have a very large scale institutional framework that did enjoy political legitimacy. I would say it’s going to lose that. We have to start from the bottom up again and go through a similar progression depending on what scale we’re trying to operate at. So I would say we’re going to be looking at things like time-banking, the exchange of time with no need to exchange money, things like local currencies, so that when the main currency has ceased to be available or has ceased to function because the institutional framework is breaking down, then we have some other form of currency that functions to support the velocity of money and the availability of liquidity in a local economy.
And each local economy would have to do that for themselves. Then I think we are going to scale things up again to something that’s going to be a currency backed by some kind of commodity, whether it’s precious metals or energy or some other form of resource. I think we’re going to have something that’s actually based in something other than just faith, which is going to look like plain vanilla financing in comparison to what we’re used to. What we’re used to is financial innovation and those are two words that should never be in the same sentence because it only means Ponzi scheme. So we’re going to outlaw a whole lot of Ponzi dynamics, and move into something that’s much more grounded in underlying real resources, I would say. So it’s a question of scaling things up again from the simple to the more complex, getting to the point where the trust allows you to maintain an institutional framework that actually works, and I think we will go through that progression over a number of years.
KF: You mentioned there outlawing the Ponzi game. Behind that sits the very profitable return on investment that certain forms of business activity encourage and deliver. How do you feel that would play out?
NF: Well, basically what happens in periods of speculative activity – when you have a speculative bubble like we have had this time, returns to speculative activity get very much larger, so the returns to capital are much larger than the returns to labour, and you get more and more rewards for speculation in comparison to actually doing any kind of real work. So, speculation becomes a parasite on the real economy, but eventually you reach a limit in terms of your speculative bubble, which is where we are at the moment. Then that bubble will burst and you go back to something that will be a lot more grounded in real work, but the returns on investment will be a fraction of what people have come to expect, because typically these high returns that people are looking for are all grounded in speculative activity. And in fact these high rates of return, relatively speaking, are a reflection of the risk of the underlying business, but they fail to accurately reflect that risk. In other words, when you chase yield, you are chasing risk, but that yield is not adequate compensation for the risk that you’re taking.
So you actually run the risk of losing all the income and all the capital – that’s one of the major problems that you have in a financial crisis – the people who’ve been playing the Ponzi scheme lose everything. So for the people who have been working more in the real economy, especially where things are based on essential goods and services with local supply chains and local distributions networks, there is no reason that shouldn’t continue. You may have a sticky patch when customers don’t have any money for a while, but it is much more resilient and robust if it’s local and it’s not part of the speculative economy. But people who do things like that are going to be accepting very low rates of return – very low margins in comparison to what people are used to, but that’s a reflection of less risk.
KF: So your hopes to reform this speculative bubble revolve around self-destruction on behalf of the rent-seekers, is that what you’re saying?
NF: Yes, well, that’s baked in the cake, pretty much. When you have an enormous credit expansion, it is going to implode because you build an enormous pile of promises that cannot possibly be kept. And what this means is everything is under-collateralised – you have this tiny little bit of collateral and this massive amount of loans that is backed by this small amount of collateral. What this means is we’re all playing a giant game of musical chairs. There’s about one chair for every hundred people playing the game. As long as we’re all up and dancing we don’t notice how few chairs there are, but when the music stops, the people best positioned to understand the rules of the game are going to grab a chair.
Everybody else’s claims will disappear because they were excess claims to underlying real wealth – they were virtual wealth, not grounded in anything real, and so you have this crash. Now, lots of people who hold excess claims to underlying real wealth are currently very wealthy people, so that whole rentier economy I think is going to implode and a lot of the games will end up in the hands of wealthy people but by no means do all wealthy people come out of this looking particularly good, because they are often in a position to have their assets most at risk, all in financial assets that could be revalued at pennies on the dollar from one day to the next. People with real physical assets are likely to be considerably better off.
And in fact, one of the things I’m trying to do – understanding that I can’t get any more wealth out of the collapsing the Ponzi scheme that was going to come out otherwise –, what I’m trying to do is redirect it. By teaching ordinary people how the economy works, I’m trying to make sure that some of what comes out of the collapsing Ponzi scheme ends up at the base of the pyramid in the hands of ordinary people who are best positioned to do something with it. Otherwise it will all disappear into the back pockets of bankers or disappear into a giant black hole of credit destruction. So I do think that the bursting of that bubble is absolutely baked in the cake at this point – you can’t prevent it, you just have to see it coming, prepare accordingly, and then work through the crunch period and try and something better at the other side.
KF: I remember hearing you, post-the global financial crisis, being one of the first to really talk about the role of deflation and from that there would be a falling money supply and this would impact upon each other and from that there would be an extended recessionary period. Whilst that has played out in America, it has been fascinating to see the disjoint between economic theory and practice in terms of the extortionate amount of money that is being printed into the economy, and I’m just wondering how this money printing phenomenon is playing out into your forecasting of future trends.
NF: It’s not changing anything at all because if you look at what they’re doing they’re not printing money. Nobody has a printing press and is generating physical currency. What they’re doing is monetizing debt. So they’re attempting to engage the engines of credit expansion, like fractional reserve banking and securitization. They’re putting money into the banking system in the expectation that this will then be lent into real economy, that we’ll have a multiplier effect in the inverse proportion to the reserve requirement, and then that will go through another engine of securitization. So it would be, if it worked, a way of reigniting the Ponzi scheme of credit expansion, but it only works if you have willing borrowers and lending.
Because the engines of credit expansion are breaking down – the lenders are coming to understand about risk, the borrowers are mostly maxed out anyway, – what’s actually happening is the banks in the United States are taking that bailout money that they are being handed by the Federal Reserve and putting it back on deposit with the Federal Reserve, so it is not getting out into the real economy, it’s having no multiplier effect whatsoever, and in any case, even though those numbers look very large, they’re absolutely trivial in comparison to the outstanding debt. So it’s really not going to have any effect at all. They would like you to think that they have the control over the monetary system that they imply that they do, and that they have the ability to inflate the currency because the last thing in the world they want you to think is that it might be a case of deflation, where the banks might close and there might be another Cyprus.
The minute a critical mass of people start thinking that then the game will be over, so they don’t want anybody thinking that – they would rather you think nobody in their right mind should hold cash because they’re just going to print money like there’s no tomorrow, so your cash won’t be worth anything, so you might as well go out and get in debt up to your eyeballs and have a house and fancy cars and everything else. This very much suits the agenda of the powers that be because it keeps people from understanding what the real risks, keeps using those people as engines of credit expansion in a very predatory way and is going to leave that whole generation of people as empty bag holders when the Ponzi scheme collapses. So, I’m trying to explain how the world really works and point out that those are not the risks that we’re facing at all – the risks are to do with too much debt and being over-extended and over-leveraged. The risk is not that your money will not be worth anything. The risk is that you might lose it all in a systemic banking crisis.
KF: I’m horrified by what’s going on in the world of private equity where we have groups like Blackstone Capital and Colonial scouring the world – they’re setting up giant real-estate investment trusts in China, through Australia; they were buying up 10,000-odd properties in America last year and really starting to push this bubble back into play and ironically they’re raising fresh capital rather than relying on cheap federal-related finance. Property investors have been sold that there is little risk because we have a shortage of housing, we have a naturally rising population augmented with some immigration as well, and we have the Chinese boom continuing and from that it’s almost at the point now where young people are being conned into believing that paying 40% of your income on somewhere to live is perfectly rational, regardless of the fact that in the mid-90s people were borrowing $100,000 for a mortgage on average versus about $200,000 today.
NF: Absolutely, this is predatory. The whole idea, especially for young people, is to convince them to be engines of credit expansion: you must have a house – you haven’t arrived, you haven’t grown up until you own your own home, therefore whatever the cost you must borrow all this money and buy something. So it has been pushing up prices because there is a lot of money that people are allowed to borrow, so people have access to borrowing at relatively moderate rates of interest, plus there is money coming from overseas that has been pushing up marginal prices, but nothing continues forever – when people say “but it’s different here”, or “it’s different this time, we can justify these valuations”, this is simply what they say every single time there is a bubble. Every single time in history there is a bubble, people are told it’s different this time and it never ever is. So of course property can fall – property can fall a very, very long way. And it can take an extremely long time to recover.
A couple of examples that I’m familiar with – if you look at what happened to property prices in real terms in Holland after they moved away from their period of being a major global naval power, it took three hundred years for their property values to recover. After the fall of the Roman Empire, it took 1500 years for property prices to recover. So, of course they can fall and they can stay down for a very long time. The thing is, if the asset price falls, the debt is still there and you owe the difference, so this is a recipe for indentured servitude – debtors’ prison – and turning debt slavery into real slavery, perhaps, or being strong-armed into the military. So I am absolutely determined to keep as many young people out of trouble as I possibly can. For them to start off behind the 8-ball before they have even had a chance is just a horrible thing to do to the younger generation.
I think people need to look at the situation with renting and say renting is not throwing money away, renting is paying someone else a fee to take the property price risk for you, and that is going to be a really good bet over the next few years. So, just don’t get yourself over-leveraged at a time when the leverage game is coming to an end.
KF: I agree with most of what you’re saying but what I can’t fall into line with is this let’s just lay down and let the system collapse around us – don’t you think that while these huge returns on investment in the land-based Ponzi game continue, wouldn’t it be effective or part of a diversity of tactics to be looking to reform the system that used to finance teachers, that used to finance our public rail systems and so forth, and that is the tax system.
NF: The problem is the system has an enormous amount of inertia. Even if you had the best people running it, who were incredibly well-informed, incredibly public-spirited and prepared to do something about it, the system has so much inertia that they wouldn’t be able to achieve anything in the amount of time that there is available. So you simply are in a position where the system as it exists is unreformable, and in fact there has been comprehensive regulatory capture, so the rules are written by the very people who benefit from them the most. And these are the people least likely to go changing the status quo, because it has served them so well and often they can’t see that it wouldn’t serve them exactly the same way in the future (even though I don’t think it will, but they think it will). So why would they reform that?
We actually do not have a democratic process. In most developed countries, what we have is the appearance of democracy, we have the institutions, but they have been hollowed out and they no longer serve the functions in the way that they once did. So, comprehensive regulatory capture – and most of what passes for politics these days is political theatre, or prolefeed, if you like, in Orwellian terms, so this is not the ability of ordinary people to actually generate change at the political level. I think those days are gone, and they have been gone for quite a long time, so we’re not in a position to be able to vote for that kind of change. I don’t think any change of policy is actually going to make any difference because I think we’re going to be in crisis in the next couple of years in a place like this, and so that whole level of governance will be even less effective than it is now, and I would simply like to see us build something from the bottom up because I think we stand a chance of being far more effective if we work at the most effective organisational scale, which will depend on where the trust horizon lies.
When the trust horizon contracts, as I would argue it will over the next couple of years, then the effective organisational scale will be much smaller. And I think, because we have limited capacity, we need to use that capacity as effectively as we possibly can, which means working at a more local level.
KF: So, in summing up then, Nicole Foss, what should we be learning right now in preparation for the climate challenge future?
NF: Well, we really need to look at the big picture, and how different things fit together. So, there is a lot of focus on certain issues – there has been a lot of focus on climate, for instance, but a lot of people who are focusing on that are not looking at other subsystems like finance, and the problem is that if you fall at the first hurdle, you’re out of the race, because you lose your capacity to do anything about the challenges that come later. So, if we don’t understand the financial system then we will lose our capacity to do anything about climate thereafter, or about energy, or the other resource limits that we’re approaching. So, I think we absolutely have to prioritize the different subsystems of reality, look at the big picture and navigate our way through what will be several decades of upheaval, because we really are reaching our limits to growth in just about every way all at the same time. And we have to be able to work our way through that, and that’s going to cause a bottleneck, I think, and that’s going to be very hard on a lot of people. But the point is to minimise the pain – to mitigate the impact. You can’t prevent the contraction from happening, but you can mitigate the impact. The way I put that is that you can’t change the waves, but you can learn to surf, and that’s what we need to do.